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Sir, in this question, the paragraph
The finance director has completed a review of accounts receivable management and has proposed staff training and operating procedure improvements, which he believes will reduce accounts receivable days to the average sector value of 53 days. This reduction would take six months to achieve from the current date, with an equal reduction in each month. He has also proposed changes to inventory management methods, which he hopes will reduce inventory days by two days per month each month over a three-month period from the current date. He does not expect any change in the current level of accounts payable.
The total reduction of receivables is 12 days so if it take 6 months to reach the goal, the receivables will reduce by 2 days a month.
My question is that why do we add only 2 days of receivables to cash flows of month 1, 2 and 3 instead of 2 days in month one, 4 days in month 2 and 6 days in month 3?
Shouldn’t the effect of reducing the receivables have a cumulative effect?
Same for inventory
I need to look at the whole question – please tell me the exam month and year.
The effect won’t be cumulative – each time it is a ‘one-off’ effect.
Let me try and explain with a little example.
Suppose we sell $100 a month, and customers currently take 2 months credit (and this has been the case for a long time). Then we will be receiving cash of $100 every month (from sales two months earlier).
Suppose this month we change and start only giving 1 months credit.
This month we will still just receive 100 from the sale of 2 months ago (because they were getting 2 months credit).
Next month we will receive 100 for the sale last month (because they were also getting 2 months credit) but we will also receive 100 from this months sales (because they were only given 1 months credit). So next month we will receive 200.However, from then on we will be back to getting 100 a month – from the sales in the month before.
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